3 stealth tax traps

@FortuneMagazine July 22, 2011: 2:03 PM ET
The rising impact of stealth taxes

FORTUNE -- Congressional gridlock over whether to cut or raise income taxes is obscuring a different threat to six-figure earners: a host of stealth taxes implemented in the name of deficit reduction. Many of the provisions, as with the dreaded alternative minimum tax, have never been adjusted for inflation. As a result, they have morphed into tax traps for upper-middle-income earners. Here are three of the most glaring examples.

Two of the new stealth taxes were created by last year's landmark health care reform bill. First, the Medicare payroll tax is going up. The tax is now 2.9% on all wages; employers and employees each pay 1.45%. Starting in 2013, individuals making more than $200,000 (and couples making more than $250,000) will have to kick in an additional 0.9% on wages above that amount.

A second, much heftier increase also takes effect in 2013, in the form of an unprecedented new 3.8% Medicare tax on investment income. It will strike filers whose "modified adjusted gross income" -- roughly speaking, wages plus investment income -- tops $200,000 for individuals or $250,000 for couples. (The tax will apply to whichever is less: investment income or the amount by which modified adjusted gross income exceeds the income threshold.) Investment income will include taxable capital gains, dividends, interest income, annuities, royalties, and rents. The thresholds for both of the new Medicare taxes will not be indexed for inflation. So they'll snag an increasing number of taxpayers over time.

Finally there's the taxation of Social Security benefits. In 1984, when the Social Security system faced a funding crisis, Congress enacted a law to make the wealthiest recipients pay income taxes on their benefits. Specifically, up to 50% of Social Security benefits became taxable when half of these benefits, plus a retiree's other income -- including retirement plan payouts and investment income -- exceeded $25,000 a year ($32,000 for couples). Back then, only about 10% of retirees had incomes that topped that level. In 1994 a second layer of tax was put in place: 85% of your Social Security benefits became taxable if half of your Social Security benefit plus your "other" income topped $34,000, or $44,000 as a couple.

Once again, none of those crucial thresholds were indexed to inflation; today the Social Security tax still kicks in at $25,000. As a result, about a third of retirees are now paying federal income tax on their Social Security benefits. A decade from now, an estimated 45% will owe the tax.

Don't expect relief from the government on any of those stealth taxes. Your best bet is to generate as much income as possible from sources that don't trigger them. One way to accomplish that is to put your retirement savings into a Roth IRA or Roth 401(k), where contributions are made with after-tax dollars, and all future investment gains and withdrawals are tax-free. At the end of the day, you may never be able to shield yourself completely from stealth taxes. But you can at least minimize the bite.

--A former compensation consultant, Janice Revell has been writing about personal finance since 2000. To top of page

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